The Good Science of Bad Money Mistakes

201728Oct

Earlier this month, the behavioural economist Richard Thaler, was awarded this year’s Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel. The award is more popularly called the Nobel Prize in Economic Sciences.

Behavioural economics is an area of economics that looks at psychological aspects of human behaviour to understand economic decision making.

It draws from the idea that humans are irrational beings and to drive them towards optimal behaviour they need suitable nudges.

“The most valuable theory of Thaler that policymakers have come to accept is that of mental accounting. Pure economists believe that money is fungible, but behavioural economics say that money is non-fungible. For example,the money that one gets as a bonus will be spent differently than the same money received as salary. While the later will be used to pay off one’s expensive loan, chances are that the former will be used for more frivolous expenditures like a vacation because both the monies seem to come from different mental accounts,” said Biju Dominic, a behavioural science expert and chief executive officer of Final Mile Consulting, a company that describes itself as a behaviour architect.

“This of course stems from the fact that people are irrational, so in order to drive appropriate behaviour it’s important, as per Thaler, to create suitable nudges,” he added.

This is relevant not just for the policymakers, but for financial advisers too. “Nudge is an important aspect of financial planning. It’s important to let customers feel in charge. At the same time we need to work on managing expectations and guide them. Encouraging them to list their financial goals is one example of a nudge because it puts a lot of things in perspective and it becomes easier to explain concepts of time horizon, investment needed and asset classes,” said Shyam Sekhar, founder, ithought, an investment advisory firm.

“Making a financial plan is not that difficult, (the difficult part is) is dealing with behavioural aspects of the customer. The expectations of customers are often irrational and the mindset is often rigid in money matters. Therefore, the biggest challenge for a financial adviser is to work on the mindset because once that’s been addressed, it’s easier for the customer to stay the course,” he said.

We asked financial advisers about these irrational behaviours and they pointed out the three most common ones. Read on.

Past performance guarantees future performance

According to Shweta Jain, a certified financial planner and chief operating officer of International Money Matters Pvt. Ltd, how a customer reacts to an asset class depends on her past experience. “People tend to believe they are lucky or unlucky depending on their past experience and are not willing to accept that past experiences might be an aberration. So, someone who loses money in stock trading will stay out of equities forever. Thaler calls it the hindsight bias or misremembering,” said Jain. “In fact if the person enters the market again, she is likely to make the same mistake: Give into greed and enter the market at its peak and chicken out when the market crashes, reinforcing the hindsight bias,” she added.

Needless to say, this mindset can cause serious damage to your wealth. “When you do well, you assume you will always do well. This makes people overconfident, making them more vulnerable to mistakes. It’s therefore important for financial advisers to break the notion that past performance guarantees future outcome,” said Sekhar. “You assume a bull run will stay forever and are willing to buy any financial product that offers market returns. In fact, this false sense of euphoria is what causes people to make maximum mistakes and most susceptible to misselling,” he added.

Herd mentality

Of course, herd mentality doesn’t apply to money matters alone. But this ‘me too’ approach, which also stems from greed and a fear of being left out, can be counter-productive in money matters. “We often have clients who come with very specific fund recommendations. They want to put their money in small-cap and mid-cap funds because their friends, colleagues or relatives have invested in those funds and got good returns. So the clients want to invest in the same fund irrespective of market conditions. This is because they feel left out and have the notion that mid-cap will always offer handsome returns,” said Kothari. “In a bull market, it is particularly difficult to reason with them because they don’t want to lose the opportunity. They suddenly become risk takers and assume a false sense of awareness, which make them overconfident,” he added. But what happens when reality comes crashing? “They might end up making losses but since everyone is making losses too, they are okay,” explained Jain.

Inability to cut your losses

The irrational mind is unable to let go. Kothari said that he often advises his clients to surrender endowment and money-back life insurance policies and divert the investment to higher-yielding products. “Even if it comes at a huge opportunity cost, they will wait for surrender penalty to drop before pulling out. This is because they want their money back at the very least,” said Kothari. According to Jain, “Investors tend to throw good money after bad money to recover losses. Because the pain of losing the second Rs1 lakh is less than losing the first Rs1 lakh.” Jain elaborated with another example: “For example, a shoe that doesn’t fit, we will still wear to get our money’s worth even if it’s illogical because money spent is money lost. But if we don’t use it, it would hurt us even more,” added Jain.

To overcome irrational behaviour, it is important to accept that irrationality is intrinsic to human behaviour. If you don’t, regardless of all the knowledge and awareness at your disposal, you will most likely fall into the same trap again and again.